Nonlinear Pricing in an Oligopoly Market: The Case of Specialty Co¤ee

Firms that practice second-degree price discrimination may intentionally distort product characteristics away from their e¢cient levels (e.g., the small version of a product is “too small.”) This paper o¤ers the ...rst empirical study of this product design issue. Using data from a specialty co¤ee market, I estimate a structural utility model that allows for consumer screening under vertical preference heterogeneity. Comparisons of cost data and the estimated bene...ts from changing product characteristics suggest that some of the central predictions of nonlinear pricing theory are realized in the observed market. Product design distortions are relatively large for drinks that are not the most pro...table but over which the ...rms hold market power. The estimated distortions decrease toward zero for the products with the highest price-cost margins; this result provides empirical support for the “no distortion at the top” prediction from theory. ¤Olin School of Business, Washington University, St. Louis MO 63130. Email: [email protected]. Phone: 314-935-4915. This paper is a condensed version of my University of Virginia doctoral dissertation. I would like to thank my advisors – Simon Anderson, Steve Stern, and Maxim Engers – for many helpful comments and suggestions. Andrew Cohen, Peter Davis, Phillip Leslie, and Bart Hamilton also o¤ered valuable advice. Data and information on the Charlottesville, VA co¤ee market were generously provided by Diane McClellan and Susan Presto at Aramark/Greenberry’s, John Salidis of Espresso Corner, Joseph and William Trager of Higher Grounds, and Robert Harris at Starbucks. Je¤ery Tilman at UVa’s Facilities Management Department and Michael Furlough of the UVa Geospatial and Statistical Data Center provided information and analysis that were crucial in constructing consumer population data. Finally, I would like to thank my spring 2000 Intermediate Microeconomics students, who provided invaluable assistance in collecting data.